Why the Fed should care about climate change

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Climate change will cause growing losses to infrastructure and property and slow economic growth, making it “relevant” to Federal Reserve policymakers, according to a Federal Reserve Bank of San Francisco Economic Letter published Monday.

The effects of trying to limit climate change or adapt to it and the risks associated with these attempts, “are relevant considerations for the Federal Reserve in fulfilling its mandate for macroeconomic and financial stability,” writes Glenn D. Rudebusch, senior policy advisor and executive vice president in the Bank’s Economic Research Department.

"[C]limate-related financial risks could affect the economy through elevated credit spreads, greater precautionary saving, and, in the extreme, a financial crisis," he wrote.

In addition to the financial risks associated with damage caused by climate change — including “potential loan losses at banks resulting from the business interruptions and bankruptcies caused by storms, droughts, wildfires, and other extreme events” —transition risks, including “unexpected losses in the value of assets or companies that depend on fossil fuels,” need to be factored in.

Long-term risks still create short-term consequences, he writes. Also, financial firms that make loans to businesses or individuals impacted by climate change “face substantial climate-based credit risk exposure,” Rudebusch notes.

“If such exposures were broadly correlated across regions or industries, the resulting climate-based risk could threaten the stability of the financial system as a whole and be of macroprudential concern,” he said. “In response, the financial supervisory authorities in a number of countries have encouraged financial institutions to disclose any climate-related financial risks and to conduct ‘climate stress tests.’”

Other reasons central banks need to be concerned about climate change: “climate-related financial risks could affect the economy through elevated credit spreads, greater precautionary saving, and, in the extreme, a financial crisis.”

In addition, climate changed could lead to “larger and more frequent macroeconomic shocks” and result in “infrastructure damage, agricultural losses, and commodity price spikes.” Even if drought, flood or hurricanes worsened by climate change strike outside the U.S., they can “disrupt exports, imports, and supply chains.”

Higher temperatures, according to researchers, have “slowed growth in a variety of sectors, and could cut output “by more than 1⁄2 percentage point later in this century.”

Spending on methods to soften the effects of climate change — seawalls, etc. — “is expected to increasingly divert resources from productive capital accumulation,” according to Rudebusch. “In short, climate change is becoming relevant for a range of macroeconomic issues, including potential output growth, capital formation, productivity, and the long-run level of the real interest rate.”

While monetary policy decisions generally exclude “temporary disturbances from weather events like hurricanes or blizzards,” he notes, these shocks may “grow in size and frequency and their disruptive effects could become more persistent and harder to ignore.”

And those who dismiss the costs of climate change because they “will occur well past the usual policy forecast horizon,” Rudebusch points out that “central banks routinely consider the policy implications of demographic trends, such as declining labor force participation, which have long-run effects much like climate change.”

Equity and long-term financial asset prices measure “expected future conditions, so even climate risks decades ahead can have near-term financial consequences. Climate change could also be a factor in achieving and maintaining low inflation. It took a decade or two — a relevant time scale for climate change — for the Fed to achieve its inflation objective after the Great Inflation of the 1970s and the Great Recession. Finally, the economic research that quantifies optimal monetary policy routinely uses a very long-run perspective that takes into account inflation and output quite far out in the future.”

Despite the importance for the Fed to consider climate change, Rudebusch concludes, it “is not in a position to use monetary policy actively to foster a transition to a low-carbon economy.”

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